UNITED
STATES
 SECURITIES
AND EXCHANGE COMMISSION
 Washington,
D.C. 20549
  FORM
10-Q
  (Mark
One)
 x
              QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934
  For the
quarterly period ended September 30, 2008
  OR
   ̈
              TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934
  For the
transition period from ________ to _________
  Commission
file number 000-49636
 
  VIKING
SYSTEMS, INC.
 (Exact
name of registrant as specified in its charter)
  Delaware
              
              86-0913802(State
      or other jurisdiction of
                incorporation
      or organization)
              
              (I.R.S.
      Employer
                Identification
      No.)
 
 134 Flanders Road,
Westborough, MA 01581
 (Address
of principal executive offices) (Zip Code)
  (508)
366-3668
 (Registrant’s
telephone number, including area code)
  Indicate
by check mark whether the registrant (1) has filed all reports required to
be filed by Section 13 or 15 (d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. YES xNO  ̈
  Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
the definitions of “large accelerated filer,” “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act.
 Large
      accelerated filer    ̈
              
              Accelerated
      filer    ̈Non-accelerated
      filer (Do not check if a smaller reporting company) ̈
              
              Smaller
      reporting company   x
  Indicate
by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). YES  ̈NO x
  The
registrant had 42,715,110 shares of common stock, $0.001 par value per share,
outstanding as of  November 12, 2008.
  
  FORM
10-Q
 
 FINANCIAL
STATEMENTS AND SCHEDULES
 VIKING
SYSTEMS, INC.
 
 For
the Quarter ended September 30, 2008
 
 PART I - FINANCIAL
INFORMATION
 
 Page
      ofForm
      10-QItem
      1.
              Financial
      Statements (unaudited):Balance
      Sheets at  September 30, 2008 and December 31,
    2007
              3Statements
      of Operations for the Three and  Nine Months Ended September 30,
      2008 and 2007
              4Statements
      of Cash Flows for the Nine Months Ended September 30, 2008 and
      2007
              5-6Notes
      to Financial Statements
              7-13Item
      2.
              Management's
      Discussion and Analysis of Financial Condition and Results of
      Operations
              14-20Item
      3
              Quantitative
      and Qualitative Disclosure About Market Risk
              20Item
      4T.
              Controls
      and Procedures
              20
  PART II - OTHER
INFORMATION
  Item
      1.
              Legal
      Proceedings
              21Item
      2.
              Unregistered
      Sales of Equity Securities and Use of Proceeds
              23Item
      3.
              Defaults
      Upon Senior Securities
              23Item
      4.
              Submission
      of Matters to a Vote of Security Holders
              23Item
      5.
              Other
      Information
              23Item
      6.
              Exhibits
              24
 
 
 2
  PART
I - FINANCIAL INFORMATION
 
 ITEM
1.   FINANCIAL STATEMENTS
 VIKING
SYSTEMS, INC.
 Balance
Sheets - Unaudited
  September30,
                2008
              
              
              December31,
                2007AssetsCurrent
      assets:Cash
      and cash equivalents
              
              $
              371,475
              
              
              $
              317,098Accounts
      receivable
              
              
              929,443
              
              
              
              1,371,913Inventories
              
              
              2,190,880
              
              
              
              1,816,621Prepaid
      expenses
              
              
              190,645
              
              
              
              64,324Other
      current assets
              
              
              -
              
              
              
              108,512Total
      current assets
              
              
              3,682,443
              
              
              
              3,678,468Property
      and equipment, net
              
              
              313,772
              
              
              
              583,372Other
      non-current assets
              
              
              -
              
              
              
              127,500Intangible
      assets, net
              
              
              227,503
              
              
              
              280,000Total
      assets
              
              $
              4,223,718
              
              
              $
              4,669,340Liabilities
      and Stockholders' Equity (Deficit)Current
      liabilities:Accounts
      payable
              
              $
              1,384,482
              
              
              $
              1,828,831Accrued
      expenses
              
              
              854,115
              
              
              
              2,662,687Deferred
      revenue
              
              
              28,712
              
              
              
              232,331Capital
      lease obligations - current
              
              
              40,051
              
              
              
              38,541Convertible
      debentures, related party net
              
              
              -
              
              
              
              506,531Convertible
      debentures, net
              
              
              -
              
              
              
              1,637,707Derivative
      liability
              
              
              -
              
              
              
              349,105Total
      current liabilities
              
              
              2,307,360
              
              
              
              7,255,733Capital
      lease obligations
              
              
              2,446
              
              
              
              35,364Commitments
      and contingencies (Note 10)Preferred
      Stock, 25,000,000 shares authorizedSeries
      B redeemable preferred stock, $0.001 par value; 0, and 7,789 shares
      outstanding at
                September
      30, 2008 and December 31, 2007, respectively (aggregate liquidation
      preference
                of  $8,814,241
      at December 31, 2007)
              
              
              -
              
              
              
              8,814,241Stockholders’
      Equity (Deficit):Common
      stock, $0.001 par value, 400,000,000 shares authorized;42,556,610 and
      1,398,681 issued and outstanding at September 30, 2008 and December
      31, 2007,
                respectively
              
              
              42,557
              
              
              
              1,399Additional
      paid-in capital
              
              
              26,398,683
              
              
              
              8,034,205Accumulated
      deficit
              
              
              (24,527,328
              )
              
              
              (19,471,602
              )Total
      stockholders' equity (deficit)
              
              
              1,913,912
              
              
              
              (11,435,998
              )Total
      liabilities and stockholders' equity (deficit)
              
              $
              4,223,718
              
              
              $
              4,669,340
  The
accompanying notes are an integral part of the financial
statements.
  3
 VIKING
SYSTEMS, INC.
 Statements
of Operations -Unaudited
  Three
      Months Ended
              
              
              Nine
      Months EndedSeptember
      30,
              
              
              September
      30,2008
              
              
              2007
              
              
              2008
              
              
              2007Sales,
      net
              
              $
              1,585,826
              
              
              $
              1,856,162
              
              
              $
              4,447,528
              
              
              $
              6,630,951Cost
      of salesCost
      of goods sold
              
              
              1,261,819
              
              
              
              1,598,833
              
              
              
              3,800,380
              
              
              
              5,013,804Inventory
      valuation charge
              
              
              372,440
              
              
              
              -
              
              
              
              372,440
              
              
              
              -Total
      cost of sales
              
              
              1,634,259
              
              
              
              1,598,833
              
              
              
              4,172,820
              
              
              
              5,013,804Gross
      (loss) profit
              
              
              (48,433
              )
              
              
              257,329
              
              
              
              274,708
              
              
              
              1,617,147Operating
      expenses:Selling
      and marketing
              
              
              278,927
              
              
              
              1,073,121
              
              
              
              1,072,491
              
              
              
              3,641,921Research
      and development
              
              
              183,711
              
              
              
              563,214
              
              
              
              613,917
              
              
              
              1,601,643General
      and administrative
              
              
              533,486
              
              
              
              1,106,199
              
              
              
              2,536,060
              
              
              
              2,486,761Total
      operating expenses
              
              
              996,124
              
              
              
              2,742,534
              
              
              
              4,222,468
              
              
              
              7,730,325Operating
      loss
              
              
              (1,044,557
              )
              
              
              (2,485,205
              )
              
              
              (3,947,760
              )
              
              
              (6,113,178
              )Other
      income (expense):Interest
      income
              
              
              1,432
              
              
              
              12,316
              
              
              
              19,503
              
              
              
              41,770Interest
      expense
              
              
              (1,272
              )
              
              
              (257,315
              )
              
              
              (3,052
              )
              
              
              (670,230
              )Loss
      on recapitalization transaction
              
              
              -
              
              
              
              -
              
              
              
              (2,703,776
              )
              
              
              -License
      Fee
              
              
              1,000,000
              
              
              
              -
              
              
              
              1,000,000
              
              
              
              -Other
      income (expense)
              
              
              798
              
              
              
              -
              
              
              
              272,298
              
              
              
              -Loss
      on abandonment of property and equipment
              
              
              -
              
              
              
              (100,883
              )
              
              
              -
              
              
              
              (100,883
              )Amortization
      of debt discount
              
              
              -
              
              
              
              (700,741
              )
              
              
              -
              
              
              
              (1,306,227
              )Accrued
      liquidated damages
              
              
              -
              
              
              
              (429,248
              )
              
              
              -
              
              
              
              (1,006,864
              )Gain
      (loss) on derivative liability
              
              
              -
              
              
              
              (2,270,162
              )
              
              
              307,061
              
              
              
              (2,886,059
              )Total
      other income (expense)
              
              
              1,000,958
              
              
              
              (3,746,033
              )
              
              
              (1,107,966
              )
              
              
              (5,928,493
              )Net
      loss
              
              $
              (43,599
              )
              
              $
              (6,231,238
              )
              
              $
              (5,055,726
              )
              
              $
              (12,041,671
              )Series
      B Preferred stock dividend
              
              
              -
              
              
              
              (156,278
              )
              
              
              -
              
              
              
              (481,001
              )Net
      loss applicable to common stockholders
              
              $
              (43,599
              )
              
              $
              (6,387,516
              )
              
              $
              (5,055,726
              )
              
              $
              (12,522,672
              )Net
      loss applicable to common stockholders per share - basic and
      diluted
              
              $
              (0.00
              )
              
              $
              (4.65
              )
              
              $
              (0.12
              )
              
              $
              (9.46
              )Weighted
      average shares - basic and diluted
              
              
              42,556,610
              
              
              
              1,373,182
              
              
              
              42,105,975
              
              
              
              1,323,893
 
 The
accompanying notes are an integral part of the financial
statements.
 
  4
   VIKING
SYSTEMS, INC.
 Statements
of Cash Flows-Unaudited
 
 Nine Months Ended
                September 30,2008
              
              
              2007Cash
      flows from operating activities:Net
      loss
              
              $
              (5,055,726
              )
              
              $
              (12,041,671
              )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Depreciation
      and amortization
              
              
              386,179
              
              
              
              409,545Stock
      based compensation expense
              
              
              965,857
              
              
              
              289,316Amortization
      of debt discount and debt issuance costs
              
              
              -
              
              
              
              1,306,227(Gain)
      loss on derivative liability
              
              
              (307,061
              )
              
              
              2,886,058Loss
      on recapitalization transaction
              
              
              2,703,776
              
              
              
              -Loss
      on abandonment of property and equipment
              
              
              -
              
              
              
              100,883Changes
      in operating assets and liabilities:Accounts
      receivable
              
              
              442,470
              
              
              
              (134,430
              )Inventories,
      net
              
              
              (357,586
              )
              
              
              (1,230,480
              )Prepaid
      expenses
              
              
              (126,321
              )
              
              
              (95,303)Other
      current assets
              
              
              108,512
              
              
              
              (124,085
              )Accounts
      payable
              
              
              (444,349
              )
              
              
              33,788Accrued
      expenses
              
              
              (535,497
              )
              
              
              1,737,256Deferred
      revenue
              
              
              (203,619
              )
              
              
              37,658Net
      cash used in operating activities
              
              
              (2,423,365
              )
              
              
              (6,825,238
              )Cash
      flows from investing activities:Purchase
      of property and equipment
              
              
              (80,755
              )
              
              
              (159,565
              )Net
      cash used in investing activities
              
              
              (80,755
              )
              
              
              (159,565
              )
 
 Cash
      flows from financing activities:Net proceeds from issuance of common
      stock
              
              
              2,589,905
              
              
              
              -Payment
      of debt offering costs
              
              
              -
              
              
              
              (84,967
              )Proceeds
      from related party notes
              
              
              -
              
              
              
              300,000Proceeds
      from exercise of stock options
              
              
              -
              
              
              
              4,000Repayment
      of capital lease obligations
              
              
              (31,408
              )
              
              
              (29,847
              )Proceeds
      from convertible debt
              
              
              -
              
              
              
              7,275,000Net
      cash provided by financing activities
              
              
              2,558,497
              
              
              
              7,464,186Net
      change in cash and cash equivalents
              
              
              54,377
              
              
              
              479,383Cash
      and cash equivalents at beginning of period
              
              
              317,098
              
              
              
              440,465Cash
      and cash equivalents at end of period
              
              $
              371,475
              
              
              $
              919,848Supplemental
      disclosure of cash flow information:Cash
      paid during the period for:Interest
              
              $
              3,039
              
              
              $
              178,368Income
      taxes
              
              $
              -
              
              
              $
              -
 
 The
accompanying notes are an integral part of the financial
statements.
 5
  VIKING
SYSTEMS, INC.
 Statements of Cash Flows-Unaudited
 (continued)
  Non-cash,
investing and financing activities:
 
 As more
fully described in Note 3 to these financial statements, during the nine months
ended September 30, 2008, the Company:
  ●
              Issued
      22,400,020 shares of common stock in exchange for all outstanding
      convertible debentures and related accrued interest and liquidated
      damages.
 
 ●
              Issued
      4,197,849 shares of common stock in exchange for all outstanding Preferred
      Stock and related accrued dividends, interest on unpaid dividends and
      liquidated damages.
 
 ●
              Issued
      warrants to purchase 11,200,011 shares of the Company’s common stock to
      the former convertible debenture holders in exchange for their then
      outstanding warrants to purchase 443,141 shares of common
      stock.
 
 ●
              Issued
      warrants to purchase 2,098,027 shares of the Company’s common stock to the
      former Preferred Stockholders in exchange for their then outstanding
      warrants to purchase 666,667 shares of common
  stock.
  During
the nine months ended September 30, 2007, the Company:
  ●
              Converted
      $350,000 principal amount of notes payable issued in December 2006 plus
      $6,534 in accrued but unpaid interest under such notes into $356,534
      of  the Company’s 8% Secured Convertible Debentures due February
      23, 2009.
  ●
              Converted
      $300,000 principal amount of notes payable issued in 2007 held by a
      related party into $300,000 original principal amount of the Company’s 8%
      Secured Convertible Debentures due February 23,
  2009.
  ●
              Issued
      80,000 shares of common stock with a fair value of $840,000 for liquidated
      damages to holders of the Company’s Series B Preferred stock in connection
      with the Company’s February 2007 issuance of its 8% Secured Convertible
      Debentures due February 23, 2009.
 
 ●
              Issued
      24,043 shares of common stock in connection with the conversion of 207
      shares of Series B Preferred stock plus certain accrued
      dividends.●
              Issued
      47,791 shares of common stock as payment for interest and liquidated
      damages on the Company’s then outstanding convertible
      debt.●
              Recorded
      a derivative liability of $5,376,533 in connection with the issuance in
      February 2007 of 8% Secured Convertible
  Debentures.
 
 
 The
accompanying notes are an integral part of the financial
statements.
 6
  1.           INTERIM
FINANCIAL STATEMENTS
 
 The
balance sheet of Viking Systems, Inc. (“we,” “us, “our,” “Viking” or the
“Company”) as of  September 30, 2008 and the statements of operations
and cash flows for the periods ended September 30, 2008 and 2007 are unaudited.
However, management, in its opinion, has made all adjustments necessary
to make the information presented not misleading. The balance sheet as of
December 31, 2007 was derived from the Company's audited financial statements.
The financial statements and notes thereto should be read in conjunction with
the financial statements and notes for the years ended December 31, 2007,
included in Viking's Form 10-KSB filed on March 31, 2008 with the Securities and
Exchange Commission. The results of operations and cash flows for the periods
ended September 30, 2008 are not necessarily indicative of results to be
expected for the fiscal year ending December 31, 2008.
 
 2.           LIQUIDITY
 
 The
accompanying interim financial statements have been prepared on a going concern
basis, which contemplates, among other things, the realization of assets and the
satisfaction of liabilities in the ordinary course of business.  For
the nine months ended September 30, 2008, the Company has recorded a net loss of
$5,055,726 and cash used in operating activities was $2,423,365.  As
of September 30, 2008, the Company had $371,475 of cash and cash equivalents
and a net working capital balance of $1,375,083.
  We
believe that our existing cash resources, combined with projected cash flows
from operations may not be sufficient to execute our business plan and continue
operations for the next twelve months.  Management has taken steps to
reduce the Company’s operating expenses, and continues to implement changes in
its strategic direction aimed at achieving profitability and positive cash
flow.    In addition, we continue to explore various strategic
alternatives, including business combinations, private placements of debt or
equity securities and strategic licensing or other arrangements.  In
this regard, in August 2008, the Company entered into a technology licensing
arrangement pursuant to which we received proceeds of $1.0
million.    We are in the process of engaging an investment
banking firm to assist management in exploring business combinations and/or
raising additional capital. However, no assurances can be given that the Company
will be successful in executing a business combination or in obtaining
additional financing on acceptable terms, on a timely basis, or at all, in which
case, the Company may be forced to make further cut backs, or cease
operations.  The interim financial statements do not include any
adjustments that might be necessary should we be unable to continue as a going
concern.
 
 3.           RECAPITALIZATION
 
 On
January 4, 2008, the Company completed execution of a Recapitalization Plan (the
“Recapitalization Plan”).  This Recapitalization Plan was developed
during the fourth quarter of 2007. In November 2007, Viking received approval,
subject to finalization of  certain terms and execution of final
documentation, from 100% of the holders of its Series B Variable Dividend
Convertible Preferred Stock (the “Preferred Stock”) and Viking’s 8% Secured
Convertible Debentures due February 23, 2009 (the “Debentures”), of the
Recapitalization Plan.  The Recapitalization Plan called for an
additional investment of between $2.5 and $3.0 million in the common stock of
Viking  (the “New Investment”) and a redistribution of Viking’s common
stock among the current holders of Viking’s common stock, Preferred Stock,
Debentures and the investors providing the New Investment.
  In
consummating the Recapitalization Plan, the redistribution of Viking’s capital
was accomplished on January 4, 2008, through the following: (i) a 1:50 “reverse
split” of Viking’s common stock, (ii) entry of Viking into a Recapitalization
Agreement with the applicable holders, pursuant to which the holders of the
Preferred Stock and Debentures exchanged their respective Viking securities
(including warrants that were issued in connection with the Preferred Stock and
the Debentures) for shares of Viking’s common stock and warrants which may be
exercised for common stock; and (iii) entry of Viking into a Securities Purchase
Agreement with those parties making the New Investment of $2.6 million pursuant
to which they were issued shares of Viking’s common stock and warrants which may
be exercised for shares of Viking’s common stock.   As part of the
recapitalization, Viking executed the Securities Purchase Agreement and
completed a sale of 14,560,037 shares of our common stock for $0.178571 per
share or aggregate consideration of $2,600,000.
 
 7
 
 Following
the consummation of the Recapitalization Plan, the equity ownership of the
Company was as follows:
  POST-RECAPITALIZATION EQUITY (excluding
      warrants)Stockholder by
      type
              
              Ownership
                of
                Outstanding
                Common
                Stock
              
              
              Percent
      Ownership
                Common
                StockPre-Recapitalization
      common stockholders
              
              
              1,398,704
              
              
              
              3.3%Pre-Recapitalization
      preferred stockholders
              
              
              4,197,849
              
              
              
              9.9%Pre-Recapitalization  debenture
      holders
              
              
              22,400,020
              
              
              
              52.6%New
      investment ($2.6 million)
              
              
              14,560,037
              
              
              
              34.2%Total—all
      holders
              
              
              42,556,610
              
              
              
              100.0%
  The total
outstanding debentures of $7,976,533 face amount with a carrying value of
$2,144,238 at December 31, 2007, plus all related interest and liquidated
damages, were exchanged for 22,400,020 shares of common
stock.  Additionally all warrants to purchase 443,141 shares of the
Company’s common stock issued with the Debentures were exchanged for warrants to
purchase 11,200,011 shares of the Company’s common stock.  The
warrants have an exercise price of $0.18 and a five year term.
 
 All of
the Company’s outstanding Preferred Stock, 7,789 shares with a carrying value of
$8,814,241 at December 31, 2007, plus all related liquidated damages, were
exchanged for 4,197,849 shares of the Company’s common stock.  No gain was
recorded on the exchange of the Preferred Stock as the book value was
reclassified to common stock (par value totaling $4,198) and the remainder of
$8,810,043  reclassified to additional paid-in capital. 
Additionally, all warrants to purchase 666,667 shares of the Company’s common
stock issued in connection with Preferred Stock were exchanged for warrants to
purchase 2,098,027 shares of the Company’s common stock.  The warrants
have an exercise price of $0.18 and a five year term.
  On
January 4, 2008, pursuant to a Securities Purchase Agreement, the Company
completed a sale of 14,560,037 shares of its common stock for $0.178571 per
share or aggregate consideration of $2,600,000, of which the Company received
proceeds of $2,600,000. Pursuant to the Securities Purchase Agreement, the
Company issued to the investors providing the New Investment warrants to
purchase up to 14,560,037 shares of common stock. The warrants have a term of
five years and are exercisable for shares of common stock at a price of $0.18
per share.
  The
purchasers of the common stock pursuant to the Securities Purchase Agreement
were three institutional investors and William C. Bopp,  at the time
the Company’s Chairman of the Board (currently Chairman and Chief Executive
Officer), who paid $1,750,000 for 9,800,024 shares of common stock and warrants
that may be exercised for 9,800,024 shares of common
stock.
 
 8
  Loss
on Recapitalization
 In
connection with the January 4, 2008 Recapitalization, the Company recorded a
non-cash charge of $2,703,776.  We determined the fair value of the
common stock issued in exchange for the Debentures based on the $0.18 price for
common shares sold as part of the Recapitalization.  The
charge comprises the following;
 
 Nine
      Months EndedSeptember
      30, 2008Debentures
      then outstanding
              
              $
              7,976,533Less
      unamortized debt discount
              
              
              (5,832,295
              )Net
      carrying value at time of recapitalization
              
              
              2,144,238Fair
      value of common stock exchanged for Debentures
              
              
              4,000,644Loss
      on conversion of debentures into common stock
              
              
              
              
              
              $
              (1,856,406
              )Write-off
      unamortized debt issue costs
              
              
              
              
              
              
              (80,738
              )Estimated
      fair value of warrants issued to Debenture and Preferred Stockholders in
      excess of  estimated fair value of warrants
      cancelled
              
              
              
              
              
              
              (2,039,705
              )Accrued
      obligations extinguished/forgiven in connection with
      Recapitalization:Debenture
      interest
              
              $
              302,306Liquidated
      damages
              
              
              849,178Interest
      on unpaid Preferred Stock dividends
              
              
              121,589Total
      gain from extinguished obligations
              
              
              
              
              
              
              1,273,073Total
      loss on Recapitalization transaction
              
              
              
              
              
              $
              (2,703,776
              )
  Reverse
Stock Split
 Effective
January 4, 2008, the Company completed a 1 for 50 reverse stock
split.  All prior period common stock share data, including warrants
and stock options to purchase common stock have been restated for all periods
presented to give effect to the reverse stock split.  Additionally per
share prices and number of shares related to convertible conversion securities
have also been restated.  Per share amounts, including loss per share,
have been increased by a factor of 50 and shares have been divided by
50.
 
 4.           LOSS
PER SHARE
 
 The
Company accounts for and discloses net loss per common share in accordance with
SFAS No. 128, "Earnings
Per Share." Basic net loss per common share is computed by dividing net
loss by the weighted average number of common shares outstanding. Diluted net
loss per common share is computed by dividing net loss by the weighted average
number of common shares and dilutive potential common share equivalents then
outstanding.
 
 Due to
the net losses for the three and nine month periods ended September 30, 2008 and
2007, potentially dilutive securities have been excluded in the calculation of
diluted loss per share because their inclusion would be anti-dilutive.
Accordingly, basic and diluted loss per share for the three and nine month
periods ended September 30, 2008 presented are the same. For the purposes of
this calculation, net loss for the three and nine months ended September 30,
2007 has been adjusted for dividends on preferred stock accrued during that
period.
 
 9
  The
following potentially dilutive common shares were excluded from the calculation
of diluted net loss per common share because their effect was antidilutive for
each of the periods presented:
  Three
      Months Ended
              
              
              Nine
      Months EndedSeptember 30,
      2008
              
              
              September 30,
      2007
              
              
              September 30,
      2008
              
              
              September 30,
      2007Convertible
      Debentures
              
              
              -
              
              
              
              886.281
              
              
              
              -
              
              
              
              886,281Convertible
      Preferred Stock
              
              
              -
              
              
              
              865,889
              
              
              
              -
              
              
              
              865,889Warrants
              
              
              27,985,019
              
              
              
              1,077,029
              
              
              
              27,985,019
              
              
              
              1,077,029Stock
      Options
              
              
              6,374,440
              
              
              
              193,680
              
              
              
              6,374,440
              
              
              
              193,680Total
              
              
              34,359,459
              
              
              
              3,022,879
              
              
              
              34,359,459
              
              
              
              3,022,879
 
 5.           INVENTORY
  Details
of our inventory account balances are as follows:
  September30,
                2008
              
              
              December31,
                2007Inventories:Parts
      and supplies
              
              $
              1,351,017
              
              
              $
              992,338Work-in-progress
              
              
              394,157
              
              
              
              548,268Finished
      goods
              
              
              943,324
              
              
              
              439,855Valuation
      reserve
              
              
              (497,618
              )
              
              
              (163,840
              )$
              2,190,880
              
              
              $
              1,816,621
 
 6.           ACCRUED
EXPENSES
 
 Accrued
expenses consist of the following:
 
 September30,
                2008
              
              
              December31,
                2007Wages
      and salaries
              
              $
              268,557
              
              
              $
              388,382Board
      of director fees
              
              
              192,013
              
              
              
              251,100Registration
      delay fees
              
              
              161,574
              
              
              
              434,214Professional
      and consulting fees
              
              
              158,001
              
              
              
              201,577Liquidated
      damages
              
              
              -
              
              
              
              849,178Interest
      on unpaid preferred stock dividends
              
              
              -
              
              
              
              121,589Debenture
      interest
              
              
              -
              
              
              
              302,306Other
      accrued expenses
              
              
              73,970
              
              
              
              114,341$
              854,115
              
              
              $
              2,662,687
  10
  7.           INCOME
TAXES
 
 Viking
accounts for income taxes using the asset and liability method. Under the asset
and liability method, deferred tax assets and liabilities are recognized for the
future tax consequences attributable to differences between the financial
statement carrying amounts of existing assets and liabilities and their
respective tax bases. Deferred tax assets and liabilities are measured using
enacted tax rates expected to apply to taxable income in the years in which
those temporary differences are expected to be recovered or settled. The effect
on deferred tax assets and liabilities of a change in tax rates is recognized in
income in the period that includes the enactment date. A valuation allowance is
recognized against deferred tax assets when it is more likely than not that the
assets will not be realized.
 
 Effective
January 1, 2007, the Company adopted the provisions of Financial Accounting
Standards Board (“FASB”) Interpretation No. 48 (“FIN 48”), “Accounting for
Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109.” The
implementation of FIN 48 had no impact on the Company's financial
statements.
  The
Company is primarily subject to U.S. federal and state income tax. Tax years
ended December 31, 2004 and after remain open to examination by U.S. federal and
state tax authorities. The Company's policy is to recognize interest and
penalties related to income tax matters in income tax expense. As of September
30, 2008 and December 31, 2007, the Company had no accruals for interest or
penalties related to income tax matters.
 
 8.           STOCK-BASED
COMPENSATION
  On
January 1, 2006, the Company adopted Statement of Financial Accounting Standards
(“SFAS”) No.123 (Revised 2004), “Share Based Payment,” (“SFAS 123R”), using the
modified prospective method. In accordance with SFAS 123R, the Company measures
the cost of employee services received in exchange for an award of equity
instruments based on the grant-date fair value of the award. That cost is
recognized over the period during which an employee is required to provide
service in exchange for the award - the requisite service period. The Company
determines the grant-date fair value of employee share options using the
Black-Scholes option-pricing model.
  During
the three months ended September 30, 2008 and 2007, the Company recorded
$120,533 and $89,998 respectively, and during the nine months ended September
30, 2008 and 2007 the Company recorded  $965,857 and $289,316,
respectively in non-cash stock-based compensation expense pursuant to SFAS
123R. As of September 30, 2008, there was approximately $1.3 million total
unrecognized compensation costs related to unvested options, which is expected
to be recognized over a weighted average period of approximately 2.5
years.
 
 The fair
value of stock options granted during the nine months ended September 30, 2008
was estimated using the Black-Scholes model with the following assumptions:
volatility of 133%, life of 5-7 years, risk-free interest rate of 3.33%,
and expected dividend yield of 0%. Volatility is based on the historical
volatility of the Company's common stock. The life of employee stock options is
based on the average of the vesting period and contractual life. The risk free
interest rate is based on U.S. Treasury constant maturity rate for the expected
life of the stock option.
 
 Using the
assumption described above, the 6,865,000 stock options granted during the nine
months ended September 30, 2008 were valued at $1,779,528.  Based on
vesting terms, $549,704 of this amount was recognized during the nine months
ended September 30, 2008, leaving $1,229,824 to be recognized over the remaining
weighted average vesting period of 2.25 years.
 
 The
following table summarizes the stock option transactions during the nine months
ended September 30, 2008:
 
 Number
      of
                Shares
              
              
              Weighted
      - Average
                Exercise
      Price
              
              
              Weighted
      -Average Remaining
                Contractual
      Life
                (in
      years)Options
      outstanding December 31, 2007
              
              
              154,840
              
              
              $
              18.50
              
              
              
              6.5Granted
              
              
              6,865,000
              
              
              $
              0.33
              
              
              
              9.67Cancelled
      and expired
              
              
              (566,400
              )
              
              $
              0.33Surrendered
              
              
              (79,000
              )
              
              $
              19.16Options
      outstanding September 30, 2008
              
              
              6,374,440
              
              
              $
              0.58
              
              
              
              9.36Options
      exercisable at September 30, 2008
              
              
              854,380
              
              
              $
              2.15
              
              
              
              9.02
   11
  During
the first quarter of 2008, shareholders approved  the Viking Systems,
Inc. 2008 Equity Incentive Plan (the “2008 Equity Plan”), and the Viking
Systems, Inc. 2008 Non-Employee Directors’ Stock Option Plan (the “Directors’
Plan,” ). The maximum number of shares that may be issued pursuant to the 2008
Equity Plan is 6,720,000 shares plus such number of shares that are issuable
pursuant to awards outstanding under the 2004 Plan as of the effective date and
which would have otherwise reverted to the share reserve of the 2004 Plan. We
have reserved a total of 1,500,000 shares of our common stock for issuance under
the Directors’ Plan.  During the nine months ended September 30, 2008,
6,715,000 shares were issued under the 2008 Equity Plan and 150,000 shares were
issued under the Directors’ Plan.
  During
the first quarter of 2008, six employees surrendered 79,000 previously issued
stock options and in the quarter ended September 30, 2008, 560,000 options
previously granted under the 2008 Plan were cancelled.  At September
30, 2008, 644,000 shares remain available for grant under the 2008 Equity
Plan.  In connection with the surrender of stock options during the
first quarter of  2008, the Company recognized the remaining non-cash
stock option compensation of $410,258 related to these stock
options.
  9. WARRANTS
TO PURCHASE COMMON STOCK
  
 The
following table summarizes warrant activity during the nine months ended
September 30, 2008:
 
 Weighted
                  Average
                
                Weighted
                  AverageShares
                
                
                Exercise
                  Price
                
                Remaining
                  LifeWarrants
      outstanding December 31, 2007
                
                
                1,299,252
                
                
                $
                8.21Expired
                
                
                (62,500
                )
                
                $
                0.35Cancelled
      in Recapitalization
                
                
                (1,109,808
                )
                
                $
                6.00Exchanged/issued
      for cancelled warrants
                
                
                13,298,038
                
                
                $
                0.18Issued
      in connection with Recapitalization sale of common stock
                
                
                14,560,037
                
                
                $
                0.18Outstanding
      September 30, 2008
                
                
                27,985,019
                
                
                $
                0.18
                
                4.25
      years
 
 10.           COMMITMENTS
AND CONTINGENCIES
 
 In
conjunction with the conversion of $4,750,000 of convertible notes into common
stock in 2006, Viking agreed to file a registration statement covering the
shares of common stock issued upon such conversion and covering the warrants
originally issued with those notes. Such shares and warrants were not
registered. Effective June 2006, Viking offered to pay to note holders, who
elect to receive it, a registration delay fee of one percent per month of their
initial principal balance. At December 31, 2007 we had accrued $434,214 related
to this matter. Effective February 15, 2008, the Securities and Exchange
Commission made revisions to its rules regarding the trading of restricted
securities. Additionally, certain holders of the convertible notes did not
respond to the Company’s 2006 proposal to pay a delay fee related to this
proposed filing.  The Company has reversed amounts accrued related to
parties that did not respond to the 2006 proposal and ceased accruing further
delay fees effective February 15, 2008.  At September 30, 2008, the
Company has accrued $161,574 related to this matter.
 
 11.           RECENT
ACCOUNTING PRONOUNCEMENTS
 
 In
September 2006, the Financial Accounting Standards Board (“FASB”) issued
Statement of Financial Accounting Standards (“SFAS”) No. 157, Fair Value
Measurements (“SFAS 157”). SFAS 157 defines fair value as used in numerous
accounting pronouncements, establishes a framework for measuring fair value
under U.S. GAAP, and expands disclosures related to the use of fair value
measures in financial statements. SFAS 157 does not expand the use of fair value
measurements in financial statements, but standardizes its definition and
guidance in U.S. GAAP. SFAS 157 emphasizes that fair value is a market-based
measurement and not an entity-specific measurement, based on an exchange
transaction in which the entity sells an asset or transfers a liability (exit
price). SFAS 157 establishes a fair value hierarchy from observable market data
as the highest level to an entity’s own fair value assumptions about market
participant assumptions as the lowest level. In February 2008, the FASB issued
FSP FAS 157-2, to defer the effective date of SFAS 157 for all nonfinancial
assets and liabilities, except those items recognized or disclosed at fair value
on an annual or more frequently recurring basis, until years beginning after
November 15, 2008. The adoption of SFAS 157 for our financial assets and
liabilities as of January 1, 2008 did not have a material effect on our
financial statements. We are currently reviewing the adoption requirements
related to our nonfinancial assets and liabilities and have not yet determined
the impact, if any, on our financial position or results of
operations.
  12
  In
February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial
Assets and Financial Liabilities - Including an amendment to FASB Statement No.
115 (“SFAS 159”). This statement permits companies to choose to measure many
financial instruments and other items at fair value. The objective is to improve
financial reporting by providing entities with the opportunity to mitigate
volatility in reported earnings caused by measuring related assets and
liabilities differently without having to apply complex hedge accounting
provisions. This Statement is expected to expand the use of fair value
measurement of accounting for financial instruments. This statement applies to
all entities, including not for profit. The fair value option established by
this statement permits all entities to measure eligible items at fair value at
specified election dates. We adopted SFAS 159 as of January 1, 2008. Upon
adoption, the Company did not elect the fair value option for any of the
eligible financial instruments, and as such, the adoption of SFAS 159 did not
have a material effect on our condensed consolidated financial
statements.
 
 In March
2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments
and Hedging Activities – an amendment of FASB Statement No. 133,” (“SFAS 161”),
which requires enhanced disclosures about an entity’s derivative and hedging
activities and thereby improves the transparency of financial reporting.
Disclosing the fair values of derivative instruments and their gains and losses
in a tabular format provides a more complete picture of the location in an
entity’s financial statements of both the derivative positions existing at
period end and the effect of using derivatives during the reporting period.
Entities are required to provide enhanced disclosures about (a) how and why an
entity uses derivative instruments, (b) how derivative instruments and related
hedged items are accounted for under Statement 133 and its related
interpretations, and (c) how derivative instruments and related hedged items
affect an entity’s financial position, financial performance, and cash flows.
SFAS 161 is effective for financial statements issued for fiscal years and
interim periods beginning after November 15, 2008. Early adoption is permitted.
The Company does not expect SFAS 161 to have a material impact on its financial
statements.
 
 In April
2008, the FASB issued FASB Staff Position (“FSP”) FAS 142-3, “Determination of
Useful Life of Intangible Assets” (“FSP FAS 142-3”). FSP FAS 142-3 amends the
factors that should be considered in developing the renewal or extension
assumptions used to determine the useful life of a recognized intangible asset
under FAS 142, “Goodwill and Other Intangible Assets.” FSP FAS 142-3 also
requires expanded disclosure related to the determination of intangible asset
useful lives. FSP FAS 142-3 is effective for fiscal years beginning after
December 15, 2008. Earlier adoption is not permitted. The Company does not
expect FSP FAS 142-3 to have a material impact on its financial
statements.
 
 In May
2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted
Accounting Policies” (“SFAS 162”), which reorganizes the GAAP hierarchy. The
purpose of the new standard is to improve financial reporting by providing a
consistent framework for determining what accounting principles should be used
when preparing the U.S. GAAP financial statements. The standard is effective 60
days after the SEC’s approval of the PCAOB’s amendments to AU Section 411. The
adoption of SFAS 162 will not have an impact on our financial position or
results of operations.
 
 In May
2008, the FASB issued FSP Accounting Principles Board Opinion (“APB”) No. 14-1,
“Accounting for Convertible Debt Instruments That May Be Settled in Cash upon
Conversion (Including Partial Cash Settlement)” (“FSP APB 14-1”), which requires
the issuer of certain convertible debt instruments that may be settled in cash
(or other assets) on conversion to separately account for the liability (debt)
and equity (conversion option) components of the instrument in a manner that
reflects the issuer’s nonconvertible debt borrowing rate. FSP APB 14-1 will be
effective for the Company on January 1, 2009 and will require retroactive
disclosure. The Company is currently evaluating the impact of adopting FSP APB
14-1 on its consolidated financial position, cash flows, and results of
operations.
 
 In June
2008, the FASB issued FSP No. EITF 03-6-1, “Determining Whether Instruments
Granted in Share-Based Payment Transactions Are Participating Securities” (“FSP
EITF 03-6-1”), which requires entities to apply the two-class method of
computing basic and diluted earnings per share for participating securities that
include awards that accrue cash dividends (whether paid or unpaid) any time
common shareholders receive dividends and those dividends do not need to be
returned to the entity if the employee forfeits the award. FSP EITF 03-6-1 will
be effective for the Company on January 1, 2009 and will require retroactive
disclosure. The Company is currently evaluating the impact of adopting FSP EITF
03-6-1 on its consolidated financial position, cash flows, and results of
operations.
  
 
 13
  ITEM
2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
 
 This
quarterly report on Form 10-Q contains forward-looking statements that involve
risks and uncertainties.  You should not place undue reliance on these
forward-looking statements.  Our actual results could differ materially
from those anticipated in the forward-looking statements for many reasons,
including the risks described in this report and other reports we file with the
Securities and Exchange Commission.  Although we believe the expectations
reflected in the forward-looking statements are reasonable,
they relate only to events as of the date on which the statements are
made.  We do not intend to update any of the forward-looking statements
after the date of this document to conform these statements to actual results or
to changes in our expectations, except as required by law.
 
 The
following discussion and analysis should be read in conjunction with the
Financial Statements and Notes thereto, and other financial information included
elsewhere in this quarterly report on Form 10-Q.
 
 Overview
 
 We are a
leading worldwide developer, manufacturer and marketer of visualization
solutions for complex minimally invasive surgery.  We partner with
medical device companies and healthcare facilities to provide surgeons with
proprietary visualization systems enabling minimally invasive surgical
procedures, that reduce patient trauma and recovery time.
 
 We
manufacture two dimensional  digital cameras that are sold to
third-party companies who sell to end users through their Original Design
Manufacturer (“ODM”) programs and Original Equipment Manufacturer (“OEM”)
programs.
  We sell
our proprietary visualization system (“3Di Vision System”) under the Viking
brand to hospitals and outpatient surgical centers through a network of
independent sales representatives in the United States and outside the United
States through our distributor network.  We also sell our CardioCam
product through these channels.
 
 In
October 2007, our board of directors approved a revised strategic direction
for our Company.  This strategy includes focusing on our ODM/OEM
business while significantly reducing the expenses associated with our 3Di
Vision Systems business.  We intend to continue our 3Di Vision Systems
business on a reduced basis by utilizing our independent sales representatives
and our existing distributor network. This strategic direction was approved by a
five-person board of directors, none of whom is on the board today.  
The currently-constituted board of directors re-evaluated this decision in
light of our subsequent experience and considered various modifications to the
business strategy.  The Board determined that such modifications would
include additional investment in our 3Di technology followed by investment in
our U.S. distribution channels.  However, we can not implement these
initiatives until either we enter into a business combination or raise
substantial capital resources.   We are in the process
of  engaging an investment banking firm to assist our management in
exploring business combinations and/or raising additional capital.
 
 We
believe that the revised strategic direction of October 2007 enabled us to
reduce expenses, primarily associated with the 3Di Vision Systems business, that
are not expected to contribute to positive cash flow in the near
term,  including the elimination of our U.S. direct sales force and a
reduction in related clinical and marketing expenses.
 
 Recapitalization
 
 On
January 4, 2008, we completed execution of a recapitalization plan (the
“Recapitalization Plan”).  This Recapitalization Plan was developed
during the fourth quarter of 2007. In November 2007, we received approval,
subject to finalization of certain terms and execution of final documentation,
from 100% of the holders of our Series B Variable Dividend Convertible Preferred
Stock (the “Preferred Stock”) and our 8% Secured Convertible Debentures due
February 23, 2009 (the “Debentures”), of the Recapitalization
Plan.  The Recapitalization Plan called for an additional investment
of between $2.5 and $3.0 million in our common stock (the “New Investment”) and
a redistribution of our common stock among the current holders of our common
stock, Preferred Stock, Debentures and the investors providing the New
Investment.
  In
consummating the Recapitalization Plan, the redistribution of our capital was
accomplished on January 4, 2008 through the following: (i) a 1:50 “reverse
split” of our common stock, (ii) entry into a Recapitalization Agreement with
the applicable holders, pursuant to which the holders of the Preferred Stock and
Debentures exchanged their respective securities held in our Company (including
warrants that were issued in connection with the Preferred Stock and the
Debentures) for shares of our common stock and warrants which may be exercised
for common stock; and (iii) entry into a Securities Purchase Agreement with
those parties making the New Investment of $2.6 million pursuant to which they
were issued shares of our common stock and warrants which may be exercised for
shares of our common stock.   As part of the recapitalization, we
executed the Securities Purchase Agreement and completed a sale of 14,560,037
shares of our common stock for $0.178571 per share, or aggregate consideration
of $2,600,000.
 
 14
 Liquidity
and Capital Resources
 
 We
historically financed our operations principally through private sales of equity
securities and convertible debt. From January 1, 2004 through September 30,
2008, we raised net proceeds of $10,750,000 through the sale of common and
preferred stock in private placements and approximately $13,600,000 through the
issuance of convertible notes and debentures. As of September 30, 2008, we had
cash of $371,475.
 
 Net cash
used in operating activities was $2,423,365 and $6,825,238 during the nine
months ended September 30, 2008 and 2007, respectively. The decrease in net cash
used in operating activities during 2008 compared with 2007 was attributable
primarily to the receipt of $1 million from a technology license agreement
during the third quarter of 2008 and a smaller operating loss in 2008, after
excluding non-cash stock option expense combined with less cash consumed in
working capital.
 
 Net cash
provided by financing activities was approximately $2.6 million and $7.4 million
during the nine months ended September 30, 2008 and 2007, respectively. The net
cash provided by financing activities in 2008 resulted from selling common stock
in connection with the Recapitalization Plan while the cash provided during the
first six months of 2007 resulted primarily from the proceeds of selling
convertible debentures.
 
 On August
5, 2008, we licensed our patent portfolio to Intuitive Surgical, Inc. pursuant
to an exclusive license agreement (the “License Agreement”).  The
License Agreement provides Intuitive Surgical with perpetual, exclusive rights
to use all of our current patents in the medical robotics field, as defined in
the License Agreement.  We maintained the right to sell
non-stereoscopic products and our current stereoscopic products that utilize the
licensed patents in the medical robotics field.  We received $1
million for the license.
 
 Absent a
business combination, we believe that we may need to raise additional capital to
execute our business plan and continue our operations for the next twelve
months.   Such financing may not be available on acceptable terms, or
at all. We do not have any arrangements with any bank, financial institutions or
investors to secure additional financing and there can be no assurance that any
such arrangement, if required or otherwise sought, would be available on terms
deemed to be commercially acceptable and in our best interests. If we fail
to secure such financing and we are not generating positive cash flow, we will
consider other options, including curtailing operations or seeking bankruptcy
protection.
 
 RESULTS
OF OPERATIONS
 
 Three
and Nine Month Periods Ended September 30, 2008 Compared with the Three and Nine
Month Periods Ended September 30, 2007
 
 Sales.  We
had sales of approximately $1,586,000 for the three months ended September 30,
2008 and of approximately $1,856,000 for the three months ended September 30,
2007, representing a decrease of approximately 15%.  Sales decreased
approximately $2,183,000 or 33% for the nine month period ending September 30,
2008 as compared with the same period in 2007.
 
 The
decrease in revenues during the third quarter of 2008 as compared with the same
quarter in the prior year was due to lower sales of our 3Di
product.  For the nine month period, sales were lower in 2008 in both
3Di and OEM products and service.  The decrease in OEM sales is a
result of fluctuations of significant specific customer demand. The decline in
3Di systems sales is a result of the transition from a sales force orientation
to indirect sales through our distribution channels. Sales to individual
customers equaling 10% or more of revenues in the three months ended September
30, 2008 were to three customers who accounted for 27%, 25% and 10% of revenues,
respectively. Sales to individual customers equaling 10% or more of revenues in
the nine months ended September 30, 2008 were to three customers who accounted
for 36%, 17% and 11% of revenues, respectively.
 
 Gross (Loss)
Profit. For the three months ended September 30, 2008, gross loss
amounted to approximately $48,000, or 3% of revenue compared with approximately
$257,000, or 14% of revenue, for the same period in 2007. Gross profit was
approximately $275,000, or 6% of revenues, for the nine months ended September
30, 2008 and approximately $1,617,000, or 24% of revenues, for the nine months
ended September 30, 2007.  Gross (loss) profit was adversely impacted
for both the three and nine month periods ended September 30, 2008 due to the
recording of approximately $372,000 of inventory reserves for slow moving and
obsolete inventory.
 
 Excluding
the charge for slow moving and obsolete inventory, gross margin was
approximately 15.5% of revenue for the nine months ended September 30, 2008
compared with 24% for the same period in the prior year.  This
decrease in gross margin percentage  is due to the higher per unit
production cost associated with lower volumes as compared with 2007 and lower
sales of non OEM products which typically carry higher gross
margins.
 
 15
 Operating
Expenses.  We incurred operating expenses of approximately
$996,000 for the three months ended September 30, 2008 and approximately
$2,742,000 for the three months ended September 30, 2007.  Excluding
non-cash stock-based compensation expense, total operating expenses for the
three months ended September 30, 2008 and 2007, and for the nine months ended
September 30, 2008 and 2007 were approximately $876,000, $2,653,000, $3,257,000
and $7,441,000 respectively. This represents decreases of 67% and 56%
respectively, in operating expenses during the three and nine
months ended September 30, 2008 compared with the same periods in
2007.  These decreases are primarily a result of cost reductions
implemented in the fourth quarter of 2007.
 
 Sales and
Marketing Expense. Sales and marketing expenses were approximately
$279,000 for the three months ended September 30, 2008 and approximately
$1,073,000 for the three months ended September 30, 2007.   For the
nine months ended September 30, 2008, sales and marketing expense was
approximately $1,073,000 compared with $3,642,000 for the same period in the
prior year.  These decreases of approximately $794,000 and $2,569,000,
respectively, are due to reductions in our marketing efforts and the elimination
in October 2007 of our 3Di direct sales force.
 
 Research and
Development Expense.  We had research and development expenses
of approximately $184,000 for the three months ended September 30, 2008 and
$563,000 for the three months ended September 30, 2007, representing a decrease
of approximately $379,000. For the nine months ended September 30, 2008,
research and development expense decreased approximately $988,000 from
$1,602,000 for the same period in the prior year to $614,000. This decrease
is due to the temporary elimination of certain expenses related to next
generation 3Di systems as well as classification of certain engineering expenses
as cost of sales for activities associated with a third party development
contract for 3D vision products.
 
 General and
Administrative Expense.  General and administrative expenses
include costs for administrative personnel, legal and accounting expenses and
various public company expenses. General and administrative expenses were
approximately $533,000 for the three months ended September 30, 2008 and
approximately $1,106,000 for the three months ended September 30,
2007.  General and administrative expenses were approximately
$2,536,000 for the nine months ended September 30, 2008 and approximately
$2,487,000 for the nine months ended September 30, 2007.  Included in
general and administrative expense for the three months ended September 30, 2008
and 2007 are non-cash stock option charges of $120,533 and $89,998,
respectively. Included in general and administrative expense for the nine months
ended September 30, 2008 and 2007 are non-cash stock option charges of $965,857
and $289,316, respectively.
 
 Excluding
the non-cash stock option charges, general and administrative expense decreased
approximately $603,000, or 59%, during the three months ended September 30, 2008
as compared with the same period in the prior year. This decrease is primarily
due to lower legal expenses, facility costs associated with the elimination of
our San Diego office during the fourth quarter of 2007, elimination of certain
patent licensing fees and the decrease in corporate related travel.
 
 For the
nine months ended September 30, 2008, general and administrative expense
decreased approximately $627,000 excluding non-cash stock option
charges.
 
 Non Operating
Income and Expenses.  During the three months ended September
30, 2008, non operating income and expense totaled to income of $1,000,958
compared with expense of $3,746,033 for the same period in 2007.  The
prior year period included a non-cash loss from derivative liabilities of
$2,270,162 and accrued liquated damages expense and amortization of debt
discount.  We had none of these items during the three months ended
September 30, 2008.
 
 For the
nine months ended September 30, 2008, we recorded non operating expense of
approximately $1,107,000.  During the first quarter of 2008, we
recorded a charge of approximately $2,704,000 related to the Recapitalization
Plan transaction (see Note 2 to the interim financial
statements).  This charge was offset by the reversal of approximately
$271,000 related to accrued fees associated with our failure to file a
registration statement for common stock and warrants issued during
2006.  During the third quarter of 2008, we recorded license fee
income of $1,000,000 and during the first quarter of 2008, we recorded a
non-cash gain of approximately $307,000 related to the decrease in value of our
derivative instruments.  For the nine months ended September 30, 2007,
we recorded total other expense of approximately $5,928,000.
 
 Subsequent
to the Recapitalization Plan, all of our outstanding derivative instruments
(warrants) were classified as equity instruments and, as such, are no longer
revalued each balance sheet date.
 
 
  16
  Operating
Loss Before Non-Cash Charges
 A
reconciliation of net loss in accordance with generally accepted accounting
principles (GAAP) to the non-GAAP measure of operating loss before non-cash
charges is as follows:
  Three
      Months Ended
                September
      30,
              
              
              Nine
      Months Ended
                September
      302008
              
              
              2007
              
              
              2008
              
              
              2007Net
      loss, as reported
              
              $
              (43,599
              )
              
              $
              (6,231,238
              )
              
              $
              (5,055,726
              )
              
              $
              (12,041,671
              )Adjustments:Total
      other (income)/expense
              
              
              (1,000,958
              )
              
              
              3,746,033
              
              
              
              1,107,966
              
              
              
              5,928,493Non-cash
      stock option expense
              
              
              120,533
              
              
              
              89,998
              
              
              
              965,857
              
              
              
              289,316Depreciation
      and amortization
              
              
              120,977
              
              
              
              155,223
              
              
              
              386,179
              
              
              
              409,545Operating
      loss before non-cash charges
              
              $
              (803,047
              )
              
              $
              (2,239,984
              )
              
              $
              (2,595,724
              )
              
              $
              (5,414,317
              )
 
 Use
of Estimates and Critical Accounting Policies
 
 This
Management's Discussion and Analysis of Financial Condition and Results of
Operations discusses our financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United
States.
 
 The
preparation of our financial statements requires management to make estimates
and assumptions that affect reported amounts of assets and liabilities and the
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. On an ongoing basis, management evaluates its estimates and
assumptions, including those related to inventory, income taxes, long lived
asset valuation, revenue recognition, stock-based compensation and derivative
liabilities. Management bases its estimates and judgments on historical
experience of operations and on various other factors that are believed to be
reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying value of assets and liabilities that are not
readily apparent from other sources. Actual results may differ from these
estimates under different assumptions or conditions.
 
 Management
believes the following critical accounting policies, among others, will affect
its more significant judgments and estimates used in the preparation of our
Financial Statements.
 
 Inventory.Parts and supplies inventories are stated at the lower of cost or market.
Cost is determined using the standard cost method which approximates actual
cost. Work-in-process and finished goods are stated at the lower of the
accumulated manufacturing costs or market.We
reduce the stated value of our inventory for obsolescence or impairment in an
amount equal to the difference between the cost of the inventory and the
estimated market value, based upon assumptions about future demand and market
conditions. If actual future demand or market conditions are less favorable than
those projected by management, additional reductions in stated value may be
required.
 
 Income Taxes.In determining the carrying value of our net deferred tax assets, we must
assess the likelihood of sufficient future taxable income in certain tax
jurisdictions, based on estimates and assumptions, to realize the benefit of
these assets. If these estimates and assumptions change in the future, we may
record a reduction in the valuation allowance, resulting in an income tax
benefit in our Statements of Operations. Management evaluates the realizability
of the deferred tax assets and assesses the valuation allowance
quarterly.
 
 Effective
January 1, 2007, we adopted the provisions of Financial Accounting Standards
Board (“FASB”) Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in
Income Taxes - an interpretation of FASB Statement No. 109. The implementation
of FIN 48 had no impact on our financial statements.
 
 We are
primarily subject to U.S. federal and state income tax. Tax years subsequent to
December 31, 2003 remain open to examination by U.S. federal and state tax
authorities. In addition, our policy is to recognize interest and penalties
related to income tax matters in income tax expense. As of September 30, 2008,
we had no accruals for interest or penalties related to income tax
matters.
  17
  Amortization and
Impairment of Long Lived Assets.Long lived assets, such as property,
equipment and intangible assets are recorded at historical cost. We amortize our
intangible assets using the straight-line method over their estimated useful
lives, usually two to five years. We review intangible assets subject to
amortization periodically to determine if any adverse conditions exist or a
change in circumstances has occurred that would indicate impairment or a change
in the remaining useful life of the applicable asset. Conditions that would
indicate impairment and trigger a more frequent impairment assessment include,
but are not limited to a significant adverse change in the legal factors or
business climate that could affect the value of an asset, or an adverse action
or assessment by a regulator. If the carrying amount of an asset exceeds its
estimated fair value, an impairment charge is recognized for the amount by which
the carrying amount exceeds the estimated fair value of the asset. Assets to be
disposed of are reported at the lower of the carrying amount or fair value, less
the estimated costs to sell. In addition, depreciation of the asset ceases.
During the quarters ended September 30, 2008 and 2007, no impairment of
long-lived assets was recorded.
 
 Revenue
Recognition. Our revenues are derived from the sale of surgical
visualization technology products to end users, distributors and original
equipment manufacturers. Revenue from the sale of products is recognized when
evidence of an arrangement exists, the product has been shipped, the selling
price is fixed or determinable,  collection is reasonably assured and
when both title and risk of loss transfer to the customer, provided that no
significant obligations remain. If installation is included as part of the
contract, revenue is not recognized until installation has occurred, or until
any remaining installation obligation is deemed to be perfunctory. Shipping and
handling costs are included in cost of sales.
 
 For the
sale of products and services as part of a multiple-element arrangement, we
allocate revenue from multiple-element arrangements to the elements based on the
relative fair value of each element. For sales of extended warranties with a
separate contract price, we defer revenue equal to the separately stated price.
Revenue associated with undelivered elements is deferred and recorded when
delivery occurs.
 
 Stock-Based
Compensation. On January 1, 2006, we adopted Statement of Financial
Accounting Standards (“SFAS”) No.123 (Revised 2004), “Share Based Payment,”
(“SFAS 123R”), using the modified prospective method. In accordance with SFAS
123R, we measure the cost of employee services received in exchange for an award
of equity instruments based on the grant-date fair value of the award. That cost
is recognized over the period during which an employee is required to provide
service in exchange for the award - the requisite service period. We determine
the grant-date fair value of employee share options using the Black-Scholes
option-pricing model.
 
 Recent
Accounting Pronouncements
  In
September 2006, the Financial Accounting Standards Board (“FASB”) issued
Statement of Financial Accounting Standards (“SFAS”) No. 157, Fair Value
Measurements (“SFAS 157”). SFAS 157 defines fair value as used in numerous
accounting pronouncements, establishes a framework for measuring fair value
under U.S. GAAP, and expands disclosures related to the use of fair value
measures in financial statements. SFAS 157 does not expand the use of fair value
measurements in financial statements, but standardizes its definition and
guidance in U.S. GAAP. SFAS 157 emphasizes that fair value is a market-based
measurement and not an entity-specific measurement, based on an exchange
transaction in which the entity sells an asset or transfers a liability (exit
price). SFAS 157 establishes a fair value hierarchy from observable market data
as the highest level to an entity’s own fair value assumptions about market
participant assumptions as the lowest level. In February 2008, the FASB issued
FSP FAS 157-2, to defer the effective date of SFAS 157 for all nonfinancial
assets and liabilities, except those items recognized or disclosed at fair value
on an annual or more frequently recurring basis, until years beginning after
November 15, 2008. The adoption of SFAS 157 for our financial assets and
liabilities as of January 1, 2008 did not have a material effect on our
financial statements. We are currently reviewing the adoption requirements
related to our nonfinancial assets and liabilities and have not yet determined
the impact, if any, on our financial position or results of
operations.
 
 In
February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial
Assets and Financial Liabilities - Including an amendment to FASB Statement No.
115 (“SFAS 159”). This statement permits companies to choose to measure many
financial instruments and other items at fair value. The objective is to improve
financial reporting by providing entities with the opportunity to mitigate
volatility in reported earnings caused by measuring related assets and
liabilities differently without having to apply complex hedge accounting
provisions. This Statement is expected to expand the use of fair value
measurement of accounting for financial instruments. This statement applies to
all entities, including not for profit. The fair value option established by
this statement permits all entities to measure eligible items at fair value at
specified election dates. We adopted SFAS 159 as of January 1, 2008. Upon
adoption, we did not elect the fair value option for any of the eligible
financial instruments, and as such, the adoption of SFAS 159 did not have a
material effect on our condensed consolidated financial statements.
 
  18
  In
December 2007, the Financial Accounting Standards Board (“FASB”) issued (SFAS) No. 160, Noncontrolling Interests in
Consolidated Financial Statements—an amendment of Accounting Research Bulletin
No. 51(“SFAS 160”). SFAS 160 establishes accounting and reporting standards for
ownership interests in subsidiaries held by parties other than the parent, the
amount of consolidated net income attributable to the parent and to the
noncontrolling interest, changes in a parent’s ownership interest, and the
valuation of retained noncontrolling equity investments when a subsidiary is
deconsolidated. SFAS 160 also establishes disclosure requirements that
clearly identify and distinguish between the interests of the parent and the
interests of the noncontrolling owners. SFAS 160 is effective for fiscal years,
and interim periods within those fiscal years, beginning on or after
December 15, 2008, with early adoption prohibited. The accounting
provisions of SFAS 160 will be effective for our Company beginning
January 1, 2009. We are currently evaluating the impact, if any, this
statement will have on our financial position, cash flows, or results of
operations, but believe it is unlikely to have a material impact.
 
 In
December 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting
Standards (SFAS) No. 141R (revised), “Business Combinations”. The
standard changes the accounting for business combinations including the
measurement of acquirer shares issued in consideration for a business
combination, the recognition of contingent consideration, the accounting for
pre-acquisition gain and loss contingencies, the recognition of capitalized
in-process research and development, the accounting for acquisition-related
restructuring cost accruals, the treatment of acquisition related transaction
costs and the recognition of changes in the acquirer’s income tax valuation
allowance. SFAS 141R is effective for fiscal years beginning after
December 15, 2008, with early adoption prohibited. We are currently
evaluating the impact, if any, this statement will have on our financial
position, cash flows, or results of operations, but believe it is unlikely to
have a material impact.
 
 In
March 2008, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 161, “Disclosures about Derivative
Instruments and Hedging Activities - an amendment of FASB Statement
No. 133” (“FAS 161”). FAS 161 requires enhanced disclosures about an
entity’s derivative and hedging activities and thereby seeks to improve the
transparency of financial reporting. Under FAS 161, entities are required to
provide enhanced disclosures about (a) how and why an entity uses
derivative instruments, (b) how derivative instruments and related hedged
items are accounted for under Statement 133 and its related interpretations, and
(c) how derivative instruments and related hedged items affect an entity’s
financial position, financial performance, and cash flows. FAS 161 will be
effective for our Company beginning January 4, 2009 (the first day of
fiscal 2009). Early application is encouraged. FAS 161 also encourages, but does
not require, comparative disclosures for earlier periods at initial adoption. We
are currently in the process of evaluating what impact FAS 161 may have on the
disclosures in our financial statements.
 
 In March
2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments
and Hedging Activities – an amendment of FASB Statement No. 133,” (“SFAS 161”),
which requires enhanced disclosures about an entity’s derivative and hedging
activities and thereby improves the transparency of financial reporting.
Disclosing the fair values of derivative instruments and their gains and losses
in a tabular format provides a more complete picture of the location in an
entity’s financial statements of both the derivative positions existing at
period end and the effect of using derivatives during the reporting period.
Entities are required to provide enhanced disclosures about (a) how and why an
entity uses derivative instruments, (b) how derivative instruments and related
hedged items are accounted for under Statement 133 and its related
interpretations, and (c) how derivative instruments and related hedged items
affect an entity’s financial position, financial performance, and cash flows.
SFAS 161 is effective for financial statements issued for fiscal years and
interim periods beginning after November 15, 2008. Early adoption is permitted.
We do not expect SFAS 161 to have a material impact on its financial
statements.
 
 In April
2008, the FASB issued FASB Staff Position (“FSP”) FAS 142-3, “Determination of
Useful Life of Intangible Assets” (“FSP FAS 142-3”). FSP FAS 142-3 amends the
factors that should be considered in developing the renewal or extension
assumptions used to determine the useful life of a recognized intangible asset
under FAS 142, “Goodwill and Other Intangible Assets.” FSP FAS 142-3 also
requires expanded disclosure related to the determination of intangible asset
useful lives. FSP FAS 142-3 is effective for fiscal years beginning after
December 15, 2008. Earlier adoption is not permitted. We do not expect FSP FAS
142-3 to have a material impact on its financial statements.
 
 In May
2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted
Accounting Policies” (“SFAS 162”), which reorganizes the GAAP hierarchy. The
purpose of the new standard is to improve financial reporting by providing a
consistent framework for determining what accounting principles should be used
when preparing the U.S. GAAP financial statements. The standard is effective 60
days after the SEC’s approval of the PCAOB’s amendments to AU Section 411. The
adoption of SFAS 162 will not have an impact on our financial position or
results of operations.
 
 19
  In May
2008, the FASB issued FSP Accounting Principles Board Opinion (“APB”) No. 14-1,
“Accounting for Convertible Debt Instruments That May Be Settled in Cash upon
Conversion (Including Partial Cash Settlement)” (“FSP APB 14-1”), which requires
the issuer of certain convertible debt instruments that may be settled in cash
(or other assets) on conversion to separately account for the liability (debt)
and equity (conversion option) components of the instrument in a manner that
reflects the issuer’s nonconvertible debt borrowing rate. FSP APB 14-1 will be
effective for our Company on January 1, 2009 and will require retroactive
disclosure. We are currently evaluating the impact of adopting FSP APB 14-1 on
our consolidated financial position, cash flows, and results of
operations.
 
 In June
2008, the FASB issued FSP No. EITF 03-6-1, “Determining Whether Instruments
Granted in Share-Based Payment Transactions Are Participating Securities” (“FSP
EITF 03-6-1”), which requires entities to apply the two-class method of
computing basic and diluted earnings per share for participating securities that
include awards that accrue cash dividends (whether paid or unpaid) any time
common shareholders receive dividends and those dividends do not need to be
returned to the entity if the employee forfeits the award. FSP EITF 03-6-1 will
be effective for our Company on January 1, 2009 and will require retroactive
disclosure. We are currently evaluating the impact of adopting FSP EITF 03-6-1
on its consolidated financial position, cash flows, and results of
operations.
 
 ITEM
3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
 
 As a
Smaller Reporting Company as defined by Rule 12b-2 of the Exchange Act and in
Item 10(f)(1) of Regulation S-K, we are electing scaled disclosure reporting
obligations and therefore are not required to provide the information requested
by this Item.
 
 ITEM
4T. CONTROLS AND PROCEDURES
  Limitations
on the Effectiveness of Controls
 
 We seek
to improve and strengthen our control processes to ensure that all of our
controls and procedures are adequate and effective. We believe that a control
system, no matter how well designed and operated, can only provide reasonable,
not absolute, assurance that the objectives of the controls system are met. In
reaching a reasonable level of assurance, management necessarily was required to
apply its judgment in evaluating the cost-benefit relationship of possible
controls and procedures. In addition, the design of any system of controls also
is based in part upon certain assumptions about the likelihood of future events,
and there can be no assurance that any design will succeed in achieving its
stated goals under all potential future conditions. Over time, a control may
become inadequate because of changes in conditions, or the degree of compliance
with policies or procedures may deteriorate. No evaluation of controls can
provide absolute assurance that all control issues and instances of fraud, if
any, within a company will be detected.  As set forth below, our Chief
Executive Officer and our Executive Vice President and Chief Financial Officer
have concluded, based on their evaluation as of the end of the period covered by
this report, that our disclosure controls and procedures were sufficiently
effective to provide reasonable assurance that the objectives of our disclosure
control system were met.
 
 Evaluation
of Effectiveness of Disclosure Controls and Procedures
 
 Our
management evaluated, with the participation of our principal executive officer
and our principal financial officer, the effectiveness of our disclosure
controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the
Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end
of the period covered by this quarterly report on Form 10-Q. Based on that
evaluation, our principal executive officer and our principal financial officer
concluded that our disclosure controls and procedures as of September 30, 2008
are effective to ensure that information we are required to disclose in reports
that we file or submit under the Exchange Act (i) are recorded, processed,
summarized and reported within the time periods specified in SEC rules and
forms, and (ii) are accumulated and communicated to our management, including
our principal executive officer and our principal financial officer, as
appropriate, to allow timely decisions regarding required reasonable assurance
that such information is accumulated and communicated to our management. Our
disclosure controls and procedures are designed to provide reasonable assurance
that such information is accumulated and communicated to our management. Our
disclosure controls and procedures include components of our internal control
over financial reporting. Management's assessment of the effectiveness of our
internal control over financial reporting is expressed at the level of
reasonable assurance that the control system, no matter how well designed and
operated, can provide only reasonable, but not absolute, assurance that the
control system's objectives will be met.
  Changes
in Internal Control over Financial Reporting
 
 There
were no changes in our internal controls over financial reporting identified in
connection with the evaluation required by paragraph (d) of Exchange Act Rules
13a-15 or 15d-15 that occurred during the last quarter that have materially
affected, or are reasonably likely to materially affect, our internal control
over financial reporting.
 
 20
  PART II - OTHER
INFORMATION
 
 ITEM
1. LEGAL PROCEEDINGS.
 
 From time
to time, we may become involved in various lawsuits and legal proceedings which
arise in the ordinary course of business. We are currently not aware of nor have
any knowledge of any such legal proceedings or claims that we believe will have,
individually or in the aggregate, a material adverse affect on our business,
financial condition or operating results.
 
 ITEM
1A. RISK FACTORS.
 
 Forward
Outlook and Risks
 
 This Form
10-Q contains and incorporates by reference certain “forward-looking statements”
within the meaning of Section 27A of the Securities Act and Section 21E of the
Exchange Act with respect to results of our operations and businesses. All
statements, other than statements of historical facts, included in this Form
10-Q, including those regarding market trends, our financial position, business
strategy, projected costs, and plans and objectives of management for future
operations, are forward-looking statements. In general, such statements are
identified by the use of forward-looking words or phrases including, but not
limited to, “intended,” “will,” “should,” “may,” “expects,” “expected,”
“anticipates,” and “anticipated” or the negative thereof or variations thereon
or similar terminology. These forward-looking statements are based on our
current expectations. Although we believe that the expectations reflected in
such forward-looking statements are reasonable, there can be no assurance that
such expectations will prove to be correct. Because forward-looking statements
involve risks and uncertainties, our actual results could differ materially.
Important factors that could cause actual results to differ materially from our
expectations are disclosed hereunder and elsewhere in this Form 10-Q and our
Form 10-KSB for the year ended December 31, 2007. These forward-looking
statements represent our judgment as of the date of this Form 10-Q. We disclaim
any intent or obligation to update our forward-looking statements after the date
of this report to conform these statements to actual results or to changes in
our expectations, except as required by law.
 
 Additional
Financing Requirements.  We believe that we may need to seek
additional financing in order to fund our operations and carry out our business
plan for the next twelve months. The general weakening of the economy and
increased financial instability of many borrowers has resulted in a general
tightening of capital availability.  Many lending and investing
institutions that have traditionally been sources of capital have experienced
significant losses and lack of liquidity. These conditions may adversely impact
our ability to raise capital. There can be no assurance that such financing will
be available on acceptable terms, or at all. We do not have any arrangements
with any bank or financial institution to secure additional financing and there
can be no assurance that any such arrangement, if required or otherwise sought,
would be available on terms deemed to be commercially acceptable and in our best
interests. Also, if we raise additional funds by selling equity or equity-based
securities, the percentage ownership of our existing stockholders will be
reduced and such equity securities may have rights, preferences or privileges
senior to those of the holders of our common stock. Any inability to obtain
additional cash as needed could have a material adverse effect on our financial
position, results of operations and ability to continue operations.
 
 Recent
deterioration in the economy and credit markets may adversely affect our future
results of operations.Our operations and performance depend
to some degree on general economic conditions and their impact on our customers’
finances and purchase decisions.  As a result of recent economic
events, potential customers may elect to defer purchases of capital equipment
items, such as the products we manufacture and supply.  Additionally,
the credit markets and the financial services industry have been experiencing a
period of upheaval characterized by the bankruptcy, failure, collapse or sale of
various financial institutions and an unprecedented level of intervention from
the United States government. While the ultimate outcome of these events cannot
be predicted, it may have a material adverse effect on our customers’ ability to
fund their operations thus adversely impacting their ability to purchase our
products or to pay for our products on a timely basis, if at
all.  These and other economic factors could have a material adverse
effect on demand for our products, the collection of payments for our products
and on our financial condition and operating results.
 
 Possibility of
Total Loss of Investment. An investment in our Company is an extremely
high risk investment, and should not be made unless the investor has no need for
current income from the invested funds and unless the investor can afford a
total loss of his or her investment.
 
 Operating
History. We were inactive in 2002 and 2003. We commenced active
operations by acquiring assets from Vista Medical Technologies, Inc. in April
2004, and 2005 was our first full year of operation. Potential investors should
be aware that there is only a limited basis upon which to evaluate our prospects
for achieving our intended business objectives. We have limited resources and
have had limited revenues since our formation.
 
 We are Controlled
by a Limited Number of Stockholders.A few of our
stockholders have significant control over our voting stock which may make it
difficult to complete some corporate transactions without their support and may
prevent a change in control.  As of September 30, 2008, our directors
and executive officers as a whole, may beneficially own 18,612,916 shares
or  43.7% of our outstanding common stock, and assuming that the
warrants and options (exercisable as of 60 days from November 3, 2008) were
exercised, may beneficially own 33,957,832 shares or  58.6% of our
outstanding common stock.  Certain of our officers and directors
disclaim beneficial ownership of certain shares included in the description
above.
  The
above-described significant stockholders may have considerable influence over
the outcome of all matters submitted to our stockholders for approval, including
the election of directors. In addition, this ownership could discourage the
acquisition of our common stock by potential investors and could have an
anti-takeover effect, possibly depressing the trading price of our common
stock.
  21
  SEC Rules
Governing the Trading of "penny stocks" Limit the Trading and Liquidity of our
Common Stock, which may Adversely Affect the Trading Price of our Common
Stock.Our
common stock currently trades on the OTC Bulletin Board. Since our common stock
continues to trade below $5.00 per share, our common stock is considered a
“penny stock” and is subject to SEC rules and regulations that impose
limitations upon the manner in which our shares can be publicly traded. These
regulations require the delivery, prior to any transaction involving a penny
stock, of a disclosure document explaining the penny stock market and the
associated risks. Under these regulations, brokers who recommend penny stocks to
persons other than established customers or certain accredited investors must
make a special written suitability determination for the purchaser and receive
the purchaser’s written agreement to a transaction prior to sale. These
regulations have the effect of limiting the trading activity of our common stock
and reducing the liquidity of an investment in our common stock.
 
 Limited Public
Market for Securities. There is a limited public market for our common
stock and we can give no assurance that a more active market will develop, or if
developed, that it will be sustained.
 
 Auditor’s Opinion
has a Going Concern Qualification. The report of our independent
registered public accounting firm dated March 31, 2008 for the year ended
December 31, 2007 includes a going concern explanatory paragraph which
states that our significant operating losses and negative operating cash
flows raise substantial doubt about our ability to continue as a going
concern.
 
 Medical
Products Industry Operations Risks
 
 We
acquired assets and operations from Vista Medical Technologies, Inc. as
described above. We also may attempt to acquire additional medical products
and operations from time to time as opportunities become available. Our
operations in the medical product industry subject us to various risks which
include, but are not limited, to the following:
 
 We Operate in a
Competitive Market. The market for medical products and services is
competitive and new offerings and technologies are becoming available
regularly. We cannot guarantee that we will compete successfully against
our potential competitors, especially those with significantly greater financial
resources or brand name recognition.
 
 If We Fail to
Retain Key Personnel and Hire, Train and Retain Additional Qualified and
Experienced Employees, We May Not Be Able to Compete Effectively.Our future success will
depend to a large extent on retaining our employees and recruiting sufficient
qualified employees to fill vacancies created by attrition or expansion of our
operations.  There is a highly competitive labor market for such staff and
there is no assurance that we will be able to attract and retain an adequate
number of suitable employees.
 
 We Are Subject To
Significant Domestic and International Regulation and May Not Be Able To Obtain
Necessary Regulatory Clearances to Sell Our Products. We sell medical
devices.The manufacture
and sale of medical devices intended for commercial distribution are subject to
extensive governmental regulation.  Our failure to comply with regulatory
requirements would jeopardize our ability to market our products. 
Noncompliance with applicable requirements can result in failure of the
regulatory agency to grant pre-market clearance or approval for devices,
withdrawal or suspension of approval, total or partial suspension of production,
fines, injunctions, civil penalties, refunds, recall or seizure of products and
criminal prosecution. Medical devices are regulated in the United States
primarily by the FDA and, to a lesser extent, by state agencies.  Sales of
medical device products outside the United States are subject to foreign
regulatory requirements that vary from country to country.  Generally,
medical devices require pre-market clearance or pre-market approval prior to
commercial distribution.  A determination that information available on the
medical device is not sufficient to grant the needed clearance or approval will
delay market introduction of the product.  In addition, material changes or
modifications to, and changes in intended use of, medical devices also are
subject to FDA review and clearance or approval.  The FDA regulates the
research, testing, manufacture, safety, effectiveness, labeling, storage, record
keeping, promotion and distribution of medical devices in the United States and
the export of unapproved medical devices from the United States to other
countries.  The time required to obtain approvals required by foreign
countries may be longer or shorter than that required for FDA clearance, and
requirements for licensing may differ from FDA requirements.  The current
regulatory environment in Europe for medical devices differs significantly from
that in the United States.
 
 We Expect to
Encounter Rapid Technological Change and Significant Competition.The
medical device market in which we compete is characterized by intensive
development efforts and rapidly advancing technology.  Our future success
will depend, in large part, upon our ability to anticipate and keep pace with
advancing technology and competing innovations.  We may not be successful
in identifying, developing and marketing new products or enhancing our existing
products. We believe that a number of large companies, with significantly
greater financial, manufacturing, marketing, distribution and technical
resources and experience than ours, are focusing on the development of
visualization products for minimally invasive surgery.
  22
 Our Operating
Results May be Adversely Affected by the Level Of Reimbursements for Surgical
Procedures Using our Products.The level of payments
for the surgical procedures, in which our products are involved, either by
Medicare or private insurance companies may have a significant impact on future
operating results.  We could be adversely affected by changes in payment
policies of government or private health care payers, particularly to the extent
any such changes affect payment for the procedure in which our products are
intended to be used.  It is a continuing trend in United States health care
for such payments to be under continual scrutiny and downward pressure.  We
believe that reimbursement in the future will be subject to increased
restrictions, both in the United States and in foreign markets and that the
overall escalating cost of medical products and services has led to and will
continue to lead to increased pressures on the health care industry, both
foreign and domestic, to reduce the cost of products and services, including
products which we offer.
 
 We expect
that our products typically will be used by hospitals and surgical centers, that
bill various third-party payers, such as governmental programs and private
insurance plans, for the health care services provided to their patients. 
Third-party payers carefully review and increasingly challenge the prices
charged for medical products and services or negotiate a flat rate fee in
advance.  Payment rates from private companies also vary depending on the
procedure performed, the third-party payer, the insurance plan and other
factors.  Medicare compensates hospitals at a predetermined fixed amount
for the costs associated with an in-patient hospitalization based on the
patient’s discharge diagnosis and compensates physicians at a pre-determined
fixed amount based on the procedure performed, regardless of the actual costs
incurred by the hospital or physician in furnishing the care and unrelated to
the specific devices or systems used in that procedure.  Medicare and other
third-party payers are increasingly scrutinizing whether to cover new products
and the level of payment for new procedures.  The flat fee reimbursement
trend is causing hospitals to control costs strictly in the context of a managed
care system in which health care providers contract to provide comprehensive
health care for a fixed cost per person.  We are unable to predict what
changes will be made in the reimbursement methods utilized by such third-party
payers.
  If we
obtain the necessary foreign regulatory registrations or approvals, market
acceptance of our products in international markets would be dependent, in part,
upon the acceptance by the prevailing health care financing system in each
country.  Health care financing systems in international markets vary
significantly by country and include both government sponsored health care
programs and private insurance.  We cannot assure you that these financing
systems will endorse the use of our products.
  We May Be Subject
To Product Liability Claims And Have Limited Insurance Coverage.By engaging in the
medical devices business, we will face an inherent business risk of
exposure to product liability claims in the event that the use of our products
results in personal injury or death.  Also, in the event that any of our
products proves to be defective, we may be required to recall or redesign such
products. We will need to maintain adequate product liability insurance
coverage.  If we are able to maintain insurance, of which there can be no
assurance, our coverage limits may not be adequate to protect us from any
liabilities we might incur in connection with the development, manufacture and
sale of our products.  Product liability insurance is expensive and in the
future may not be available to us on acceptable terms, if at all.  A
successful product liability claim or series of claims brought against us in
excess of our insurance coverage or a product recall would negatively impact our
business.
 
 ITEM
2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF
PROCEEDS.
  During
the quarter ended September 30, 2008, we did not sell any unregistered
securities.
 
 ITEM
3. DEFAULTS UPON SENIOR SECURITIES.
 
 As of
September 30, 2008, we are not in default with respect to any
indebtedness.
 
 ITEM
4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS.
 
 During
the quarter ended September 30, 2008, we did not submit any matters to a vote of
security holders.
 
 ITEM 5. OTHER
INFORMATION.
 
 None.
  23
  ITEM
6. EXHIBITS
 
 ExhibitNumber
              Exhibit3.1
              Certificate
      of Incorporation, dated June 8, 2006 (included as Exhibit 3.1 to the Form
      10-KSB filed March 31, 2008 and incorporated herein by
      reference).3.2
              Certificate
      of Preferences, Rights and Limitations of Series B Variable Dividend
      Convertible Preferred Stock, dated May 22, 2006 (included as Exhibit 4.01
      to the Form 8-K filed May 25, 2006 and incorporated herein by
      reference).
  3.3
              Bylaws
      (included as Exhibit 3.3 to the Form 10-KSB filed March 31, 2008 and
      incorporated herein by reference).31.1
              Certification
      of Principal Executive Officer in accordance with 18 U.S.C. Section 1350,
      as adopted by Section 302 of the Sarbanes- Oxley Act of
    200231.2
              Certification
      of Principal Financial Officer in accordance with 18 U.S.C. Section 1350,
      as adopted by Section 302 of the Sarbanes-Oxley Act of
  200232.1
              Certification
      of Principal Executive Officer in accordance with 18 U.S.C. Section 1350,
      as adopted by Section 906 of the Sarbanes-Oxley Act of
  200232.2
              Certification
      of Principal Financial Officer in accordance with 18 U.S.C. Section 1350,
      as adopted by Section 906 of the Sarbanes-Oxley Act of
  2002
 
 
 
 24
  SIGNATURE
 
 Pursuant
to the requirements of the Exchange Act of 1934, the registrant has caused this
report to be signed on its behalf by the undersigned thereunto duly
authorized.
 
 Dated:
      November 14, 2008
              VIKING
      SYSTEMS, INC.By /s/ William C.
      BoppChief
      Executive Officer
                (Principal
      Executive Officer)By /s/
      Robert MathewsExecutive
      Vice President and
                Chief
      Financial Officer
                (Principal
      Financial Officer and Principal Accounting
  Officer)
 
    25